The Venture Capitalists, They Must Be Crazy

Reading about Color, the mobile startup that began with around 40 million dollars and then produced a lame app, either shutting down or not made me think some about venture capitalists.

To be such a person I think you have to be crazy. Imagine putting large amounts of money into the hands of many random people and then hoping some day you get more back is pretty much nuts.

Now I've never dealt with them directly, my first startup had investors but they were mostly people with money and no idea what computers were all about (hey it was the mid 80's, even a local banker heard software and thought we made ladies undergarments). Sure I had to convince them that we could make money selling a totally radical kind of spreadsheet in the Mac market. Compared to today it was pretty simplistic: I didn't know what I was talking about and they didn't have a clue. Plus this was Texas and people knew oil and real estate but not investing in startups. None of them were any real help (and one was a real crook).

Today venture capital, angel investing and the like is big business. Even outfits like ycombinator and other incubators make a business out of helping people jump into the startup world. But the fundamental rule is that most of the funded never amount to anything at all, and only a very few survive and maybe one makes it all worthwhile. It's like being a major league baseball player in a strange league where hitting 0.050 is amazing. How can that not be nuts?

I believe VC's invest in 4 kinds of companies (or not. I just made this up).

Companies that sell something people want and are willing to pay for.

Companies that have something people want but aren't willing to pay for.

Companies that are really selling themselves.

Random crap that no one has a clue about.

The first is easy but rare today. Think Apple Computer. Think Amazon. Here you need something people want, maybe it's a brand new thing or new way to get something, but people want to actually pay for it. Eventually they get big, make real money and go public. A no-brainer for anyone to invest in. Of course some might still turn out as pets.com but still.

The second is like Facebook. OK, maybe people didn't know they would wind up with a billion customers, but who doesn't want to keep up with your friends and family? Making money is difficult or even impossible but get big enough and they go public anyway.

The third is like Hotel Tonight. They have enormous competition, a difficult to scale niche (bet you can't guess), but great PR and aggressive marketing. Since I work for one of the competition (and even wrote a competing app there) I know this market really well. They have no hope of building a profitable business. But it doesn't matter, eventually they will build a nice set of customers and a sharp brand, and one of us will buy them for a nice bundle.

The fourth is the Las Vegas roulette wheel of fun. Throw money at anything and everything and with enough volume, something amazing might eventually appear and make bundles of money in a sale or IPO. But like in Las Vegas the odds are not in your favor. Color is one of these. A weird idea coupled with a formerly successfully entrepreneur nets 40 million in free money. Free money as in gone with the wind.

So is that a travesty? A little yes and a little no. The nature of the highly speculative investment is enormous risk and the likelihood of failure. A good VC doesn't measure how much they wasted but what the final return is. You can lose 900 million dollars and then hit a big IPO that nets you 2 billion and life is grand again.

Venture capital investing is very much like gambling in that you spend a lot of time losing money hoping to score big at some point. So you have to be crazy to not go insane when you put up crazy money and rarely get a sane result. Color was a stupid idea (Daring Fireball called it a turd) but I am sure whoever put up the money was willing to add it to the pile hoping it wasn't the crap pile.

I am sure that the only people who get a venture capitalist to invest in their idea or business are people already known to them or at least to someone they trust. For me, I don't know anyone in this business. I used to think constantly of how to make new opportunities in technology into something that might make a good idea but having no access to money I eventually gave up and wrote a blog instead. A great quote I read somewhere was "an idea is worth nothing, an idea with a management team is worth something". You could also say an idea with money has potential. An idea with my pocketbook is just a pocketbook.

These days startups are a young people's game for the most part, since older folks like me are supposedly less willing to take chances and screw up our lives. The only difference can be someone with real startup experience and success where age wouldn't matter so much. Of course young people usually start on a shoestring and the more experienced usually get a big chunk. In the end though it's still likely to fail. That's the nature of the crazy VC world. Experience? Fail. Energy? Fail. Imagination? Fail. Random luck? Success.

I do however think it would be more fun to be a venture capitalist than to get money from one. Figuring out what might be a better investment, who might be more successful, what crazy idea just might be right. It might be a crazy thing to deal with so much failure but like my golf game, one hit makes all the difference. I might shoot triple digits but all it takes is one 270 yard drive down the fairway and all is well.

The one thing to keep in mind about venture capitalists, is that they are not in business to build great businesses. Sure, many wouldn't mind seeing success down the road, but they really want it to successfully give them a fine return on their gamble. Facebook make plenty of people a lot of money but I still don't think they will ever be a great business getting a few pennies for each of their billion customers. Building a real business is what the business has to do, the capital is there to give it a head start and then hope it gets somewhere good just long enough to cash out the VC's. So whatever gets an investment to that point is all they ask for.

The odds are there are a hundred Colors out there for every Facebook or Apple. If you worried about all the dead investments you'd never make any more. So you go crazy and move on to the next one.